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The company's adjusted pre-tax margin plunged by nearly 10% year over year last quarter. The second quarter looks equally bleak, but performance may improve thereafter.

Alaska Air Group's (NYSE:ALK) profitability has been in a tailspin recently. Unit revenue is under pressure due to heavy competition in Seattle and California. Meanwhile, the price of jet fuel has skyrocketed and new union contracts are driving up labor costs.

In this episode of Industry Focus: Energy, the team digs into the causes of Alaska Air's poor performance -- and its prospects for a turnaround. Management believes that merger synergies and several recently unveiled revenue initiatives will drive solid unit revenue gains over the next few years. The carrier also plans to reduce its growth rate until it improves its profitability.

A full transcript follows the video.

This video was recorded on April 26, 2018.

Sarah Priestley: Their first quarter earnings, you touched on, they were better than what they were expecting, but that's really because, I think, they brought down expectations at the end of last year. Can you can give us a run-through on how they performed?

Adam Levine-Weinberg: As you mentioned, when they provided their guidance back in January, the forecast implied that Alaska might actually lose money in the first quarter of this year. Instead, the adjusted EPS came in at $0.14, but that was still down from $0.99 a year earlier, as Alaska's pre-tax margin fell all the way from 11% to 1.3%. So, just looking at why there was this big margin decline, first, you had unit revenue fall 2.1%, which is still better than the fourth quarter, when there was a 4.1% decrease in unit revenue. This unit revenue pressure is being completely driven by new routes that were introduced over the past year. In fact, Alaska noted on the earnings call this past Monday that there was a 0.5% increase in unit revenue on routes that had been operating a year earlier. So, the decline was because new routes tend to have lower unit revenue to start, and then, if they don't show signs of improvement, they'll usually get cut. But, most routes will improve over the course of anywhere between six months and two years. The other major factor impacting the margin last quarter was a 20% increase in Alaska's average fuel price, and to a lesser extent, a 5.1% increase in non-fuel unit costs.

Priestley: That's driven by those higher labor costs that were agreed to last year, is that correct?

Levine-Weinberg: Yeah, about two-thirds of the non-fuel cost increase was driven by labor costs. There was a new contract signed with the pilots after an arbitration proceeding last fall. Then, just earlier this month, the flight attendants ratified a new agreement, which was retroactive to the beginning of the year, giving them a pay increase.

Priestley: Going from this point, how do you think Alaska Air Group is going to get back on track and improve its reputation, as it were, get back to being that stock market darling that it was in 2017?

Levine-Weinberg: I think that during the second quarter, you'll still have some trouble, because a lot of the headwinds that caused trouble for the past couple of quarters are continuing. There's actually going to be an even bigger headwind from fuel costs. Based on current fuel prices, Alaska now expects a 32% increase in its jet fuel costs, which would be a pretty substantial margin headwind. Also, the timing of Easter this year moved some revenue from the second quarter into the first quarter, because Easter was at the very beginning of April.

But, looking beyond to the second half of this year and 2019, and then also beyond 2019, there's a lot of reasons to be more hopeful. The first is that Alaska expects to get $300 million of revenue synergies from the Virgin America deal by 2021, and most of those synergies will show up in 2019 and 2020.

Another thing that's going to help is that the last Virgin America-branded flights operated on this past Tuesday, April 24th. So, going forward, there's going to be just one brand, Alaska Airlines, one tech system. That's good for revenue management, which helps increase unit revenue. It also will create some new revenue opportunities, such as connecting flights between Alaska's international partner airlines like British Airways and the former Virgin America routes. That's particularly important because San Francisco and Los Angeles, which were Virgin America's points of strength, are much bigger international gateway hubs than Seattle, so there's more of these partnering airline flights going into those two cities, where Alaska Airlines can now sell connecting tickets throughout its network.

Another thing that's going to happen is some new revenue initiatives that are not merger-related. The most notable of that was, the company is going to start selling what they call Saver Fares, which are the equivalent of basic economy, and that's going to happen probably in November or December. The idea behind these Saver Fares is, it'll be a ticket that's only for seats in the very back of the plane, and it'll be a little bit cheaper. This is a way to better segment customers, to get the one who are the most price-sensitive on the plane while getting people who are willing to pay a little more to sit further forward or to get an extra legroom seat to pay a few dollars extra. And over the course of a thousand or more flights a day, that can really add up.

Priestley: Absolutely. I noticed they're getting much stricter on their route network, which I think is really sensible, and also leveraging their fleet better. Listening to the call, they were talking about using Boeings for longer haul, Airbuses for shorter haul, and really maximizing their efficiency there. Then, another thing I've actually seen that you commented on, Adam, in an article that you wrote, is how they're cutting their capex, and how management is responding to the current environment by altering their spending quite a lot.

Levine-Weinberg: Yeah. Alaska has been growing capacity at a high single-digit rate in recent years, and they're really pulling that back to 4% in 2019 and 2020. And it's sensible, because they have a lot to digest with this Virgin America acquisition. There's certain routes that Virgin America ran that weren't profitable, and now Alaska is really taking a tough look at all of that, figuring what routes it needs. By cutting some routes, that leaves more extra capacity to start new routes that are in strategic markets. As a result, they don't need to increase their fleet size as quickly, so that's allowing them to reduce capex to $750 million for 2019 and for 2020, which will allow them to generate free cash flow, pay down debt, also maybe start buying back more stocks than they had been this year and last year.

Priestley: I always think that's a good sign from management, when they're quite responsive in terms of their expansion plans. Pulling them back if necessary shows a bit less hubris than some companies demonstrate.